Social Norm, the Informal Sector, and Unemployment

In examining the macroeconomic effects of increased government control of the informal sector, this paper develops a two-sector general-equilibrium model featuring matching frictions on the labor market and a social norm. Conducting informal work, or employing a worker informally, is associated with expected fines and payments of a moral cost, given that there is a social norm against tax evasion. This framework facilitates an analysis of how wage setting, unemployment, and the size of the informal sector are affected by punishment policies, which has been ignored in the previous literature. Furthermore, the inclusion of an endogenously determined norm against tax evasion may explain interregional differences in relative sizes of the formal and the informal sectors for similar tax and punishment systems.